February 13, 2011

Corporate taxes: the SOTU, actual (effective) tax rates, and more

In the State of the Union address (see, e.g., PBS website for SOTU address and additional links), President Obama claimed that the United States can stay on top if only it can "out-innovate, out-educate, and out-build" other countries. It is interesting that we describe our goals merely in terms of besting others, but that is the sometimes questionable legacy of American "exceptionalism."

Let's consider, in that context, how corporations, and the corporate tax, figured in the speech.

First, acknowledging the importance of government support for new areas of promising research and innovation, Obama stated that he would ask Congress "eliminate the billions in taxpayer dollars we currently give to oil companies. I don’t know if you’ve noticed, but they’re doing just fine on their own. So instead of subsidizing yesterday’s energy, let’s invest in tomorrow’s." That sounds like a good start. For decades, Big Oil has been coddled by the tax system while pushing its externalities--air, water, and land pollution--off on ordinary people. It's time that the oil industry made it on its own.

On "out-educating" other countries, the President noted that elimination of the subsidies to banks built into the loan programs. That, of course, is a good move, but leaves a lot on the table still to be done to provide educational opportunity to all Americans. Both innovation and education would be well served by a significant investment in university research, rather than the fickle "R&D" tax credit that rewards companies often for just tweaking an existing product and not for the basic, innovational research that opens new frontiers.

On building, the President noted the need for infrastructure improvements from bridges to roads to wireless technologies, essential for businesses and communities to grow in a global world. But how can you invest in infrastructure if you do not ensure that you have the tax revenues to pay for it? And the will to do that seems to be missing, both in the White House and in Congress.

On the issue of business success, President Obama first sounded a familiar and appropriate note--the problem that lobbyists for businesses have "rigged the tax code to benefit particular companies and industries. Those with accountants or lawyers to work the system can end up paying no taxes at all. But all the rest are hit with one of the highest corporate tax rates in the world. It makes no sense, and it has to change." It is clearly true that the many provisions that operate as loopholes for particular businesses (take the section 199 domestic production credit, for example) should be eliminated.

But then Obama went on to say that what was needed was simplification. That's highly questionable. Most of the complexities in the Code came in response to tax shelter transactions or other overly aggressive interpretations of the Code that assisted companies in cutting their tax bills. Each shelter requires a response in terms of more specific code language, leading to more complex provisions as the only way to combat the tax minimalization norm.

Obama suggests that we can get rid of corporate loopholes and use the savings to lower the tax rate for corporations. Maybe. But perhaps our goal should be to disincentivize aggregation of corporate entities in conglomerates that have no loyalty to country or worker, rather than allowing them to continue to move assets abroad. We should consider what provisions are necessary to allow workers to share in the profits that they help create.

Like most people preaching corporate tax reform these days, the President appears to be on board with the "received wisdom" that it is important that the US help big multinational corporations located in the US to compete in other countries and that the US statutory rate is a problem in that regard.

You can check out prior postings to see my arguments against the competitiveness argument.

Quite a few of the experts who write about corporate tax think the corporate tax rate should be reduced to zero. Their arguments are often laced with plenty of talk about how investment income ought to be favored or, another version of same, how capital invested in corporations shouldn't be taxed because it supports entrepreneurialism. That argument is inapplicable, however, for all except that part of the capital that is invested in a corporation from the outset or made as a new contribution to capital of the corporation: the "startup" capital actually supports whatever entrepreneurialism may be going on in that corporation, and new capital contributions may or may not support entrepreneurialism. (Even startups may not be entrepreneurial, but some at least are.) Most investments in corporate stock are not even invested in the corporation--they are just secondary market purchases between investors, so there is no new investment going into the corporate entity. There appears to be very little reason to treat gains from secondary market trades in corporate stock more favorably than labor income for tax purposes--those resources will be invested in something or spent, so we don't need the tax law to incentivize the investment.

The arguments for eliminating corporate tax otherwise usually boil down to a statement along the lines that "people are the only ones that really pay tax, so corporations shouldn't be taxed." That is an a priori conclusion (based on determining that people are the only "real" taxpayers), but somehow it passes for astuteness amongst many tax experts. It is claimed to be based on economic reality--that only people earn income; that it is people that run corporations but there is no "person" that is the corporation; that the corporate tax can be and is passed on from the entity to others that are people--customers, vendors, employees, shareholders. While there is a kernel of truth to each of those rationales, there is also a much larger story that they do not capture. The idea that "only people earn income" ignores the reality of corporate entities of infinite duration that may hoard millions in cash rather than pass it to the shareholder/owners. The idea that the corporation itself isn't a person (which is only relevant, of course, with the corollary that only people pay tax) has been undercut by the expanding scope of the Slaughterhouse Case decisions that treat a corporation as a person for constitutional purposes--including the recent Citizens United case that allows corporations to spend money to influence election campaigns, though they cannot (yet) vote. Though the incidence is not fully certain, one might think that it is most aptly described as passed on to shareholders since there are less corporate earnings to be distributed). If one says that similar passing along occurs whenever one person hires another (family with nanny pays nanny out of service income of family even though they pay taxes on that income; nanny treated as gettting compensation income on which nanny also pays taxes), one is warned that this is playing games and not the way proper economic analysis treats the situation since it is "inherently" different when it is an "entity" that can't "actually" do services except by the actions of the people who own and operate it, so should not be treated as earning income or paying taxes.

One could also say that corporations don't talk so they shouldn't have First Amendment rights. That wouldn't get us far with Citizens United on the books.

As a result, whether corporations are taxpayers or not and whether they have First Amendment rights or not is a matter of law. Right now, our statutory law says corporations are taxpayers and our constitutional law (as interpreted by the Supreme Court) says they also have First Amendment rights.

Remember that the statutory rate is the rate applicable under the statute to "taxable" income rather than economic income. Taxable income is almost always much lower than economic income, since there are both income exclusions (e.g., certain life insurance) and deductions and credits (e.g., the R&D credit, the section 179 "expensing" deduction) that make taxable income considerably less than economic income. As a result, most taxpayers--and especially most wealthy people and big corporations--don't pay anywhere near the statutory tax rate on their economic income. My favorite example in my basic income tax class used to be Dick Cheney. There was a year when he had millions of municipal bond interest income (excluded from taxable income): obviously, his taxable income was much lower than it would have been without that exclusion, so he paid tax on an amount that was considerably less than his economic income. In another year, he took advantage of the so-called "Katrina charitable contribution provision" that permitted taxpayers to completely reduce their taxable income to zero with their charitable contributions (which didn't have to do anything to aid Katrina victims or New Orleans). You can imagine that there'd be someone who typically made $200,000 a year in contributions and who might make $600,000 that year (and not make the $200,000 a year for the next two years) and be much better off taxwise. Of course, the fact that wealthy people own the lion's share of the financial assets of the country gives another advantage here--they can contribute stocks and get deductions for amounts that they've never paid tax on! And on and on...

Obama was correct on one thing: the federal income tax is riddled with provisions that benefit big corporations, especially Big Oil which benefits from "percentage depletion" and others that enjoy considerable benefit from the modified accelerated depreciation provisions (dating back to Reagan's time) and various bonus depreciation and expensing provisions that don't reflect the economics and have added complexity to the Code since then. Scaling back those provisions--eliminating the many subsidies for Big Oil and modifying the provisions for accelerated expensing and depreciation would be a good move.

The corporate expertise in taking advantage of loopholes or in "inventing" them (tax strategy patents, anyone?) results in US corporations pay very little in federal income tax. David Leonhardt discussed that recently in an article about The Paradox of Corporate Taxes, New York Times, Feb. 1, 2011. While noting that companies have various reasons for having low tax bills, including significant losses carried forward from earlier years to offset years of profits and significant purchases of equipment or buildings that are allowed to be "expensed" under today's capitalization and depreciation rules, another reason that many are successful is that they have developed significant expertise at avoiding taxes. Leonhardt reports that GE, for example, paid less than 15% of its corporate profits in taxes between 2005 and 2009.

G.E. is so good at avoiding taxes that some people consider its tax department to be the best in the world, even better than any law firm’s. One common strategy is maximizing the amount of profit that is officially earned in countries with low tax rates. ...

Companies that pay relatively high rates tend to be those that are not expanding rapidly and that are not as ingenious as G.E., at least on taxes. The average total tax rate for the 500 companies over the last five years — again, including federal, state, local and foreign corporate taxes — was 32.8 percent. ...The problem with the current system is that it distorts incentives. Decisions that would otherwise be inefficient for a company — and that are indeed inefficient for the larger economy — can make sense when they bring a big tax break.

But Leonhardt's numbers may make corporations look like better taxpayers than they actually are. Citizens for Tax Justice recently published a study suggesting that the contribution to tax revenues from US corporations is even lower than generally reported. According to CTJ, GE didn't pay anywhere near the 14.7% that Leonhardt claims. "GE's effective tax rate for its U.S. profits was actually just 3.4 percent over that period. Our figure is based on what GE says that it paid in U.S. corporate income taxes (called "current" taxes) divided by what GE says its pretax U.S. profits were (all from GE's annual 10K reports to shareholders, filed with the SEC)." See U.S. Corporations Are Paying Even Less in Taxes Than Recently Reported, Citizens for Tax Justice (Feb. 4, 2011). CTJ suggests that there are several reasons why some reports misreport the US income taxes paid by corporations.

First, some analysts are misreporting how the worldwide taxation system works and thus larding the corporate taxes paid to the US with taxes that corporations pay to other countries. While the US system includes worldwide income in taxable income, it also gives corporations a tax credit for taxes they have paid on their foreign income to other countries, up to the amount of tax that would have been paid in this country. So those taxes shouldn't be counted as part of the US taxes paid. As CTJ explains, "to understand how the U.S. corporate income tax is working, one must focus on U.S. taxes paid on U.S. profits. No one expects Congress to do much about taxes that U.S. corporations pay to the governments of France, Germany, or Japan!"

Second, only the "current" taxes in financial statements (available generally in SEC filings for reporting companies) are relevant. Taxes that are listed as "deferred" may be due and payable but they don't count as taxes yet. As CTJ notes," "Deferred" is a euphemism for "not paid." Corporations can defer (delay) paying taxes if, for example, they enjoy tax breaks for accelerated depreciation, which allow them to take deductions for capital investments sooner than they would if the rules were simply based on the actual life of the investment. A company could eventually pay taxes that it has "deferred." But that doesn't happen very often."

Comments

Corporate taxes: the SOTU, actual (effective) tax rates, and more

In the State of the Union address (see, e.g., PBS website for SOTU address and additional links), President Obama claimed that the United States can stay on top if only it can "out-innovate, out-educate, and out-build" other countries. It is interesting that we describe our goals merely in terms of besting others, but that is the sometimes questionable legacy of American "exceptionalism."

Let's consider, in that context, how corporations, and the corporate tax, figured in the speech.

First, acknowledging the importance of government support for new areas of promising research and innovation, Obama stated that he would ask Congress "eliminate the billions in taxpayer dollars we currently give to oil companies. I don’t know if you’ve noticed, but they’re doing just fine on their own. So instead of subsidizing yesterday’s energy, let’s invest in tomorrow’s." That sounds like a good start. For decades, Big Oil has been coddled by the tax system while pushing its externalities--air, water, and land pollution--off on ordinary people. It's time that the oil industry made it on its own.

On "out-educating" other countries, the President noted that elimination of the subsidies to banks built into the loan programs. That, of course, is a good move, but leaves a lot on the table still to be done to provide educational opportunity to all Americans. Both innovation and education would be well served by a significant investment in university research, rather than the fickle "R&D" tax credit that rewards companies often for just tweaking an existing product and not for the basic, innovational research that opens new frontiers.

On building, the President noted the need for infrastructure improvements from bridges to roads to wireless technologies, essential for businesses and communities to grow in a global world. But how can you invest in infrastructure if you do not ensure that you have the tax revenues to pay for it? And the will to do that seems to be missing, both in the White House and in Congress.

On the issue of business success, President Obama first sounded a familiar and appropriate note--the problem that lobbyists for businesses have "rigged the tax code to benefit particular companies and industries. Those with accountants or lawyers to work the system can end up paying no taxes at all. But all the rest are hit with one of the highest corporate tax rates in the world. It makes no sense, and it has to change." It is clearly true that the many provisions that operate as loopholes for particular businesses (take the section 199 domestic production credit, for example) should be eliminated.

But then Obama went on to say that what was needed was simplification. That's highly questionable. Most of the complexities in the Code came in response to tax shelter transactions or other overly aggressive interpretations of the Code that assisted companies in cutting their tax bills. Each shelter requires a response in terms of more specific code language, leading to more complex provisions as the only way to combat the tax minimalization norm.

Obama suggests that we can get rid of corporate loopholes and use the savings to lower the tax rate for corporations. Maybe. But perhaps our goal should be to disincentivize aggregation of corporate entities in conglomerates that have no loyalty to country or worker, rather than allowing them to continue to move assets abroad. We should consider what provisions are necessary to allow workers to share in the profits that they help create.

Like most people preaching corporate tax reform these days, the President appears to be on board with the "received wisdom" that it is important that the US help big multinational corporations located in the US to compete in other countries and that the US statutory rate is a problem in that regard.

You can check out prior postings to see my arguments against the competitiveness argument.

Quite a few of the experts who write about corporate tax think the corporate tax rate should be reduced to zero. Their arguments are often laced with plenty of talk about how investment income ought to be favored or, another version of same, how capital invested in corporations shouldn't be taxed because it supports entrepreneurialism. That argument is inapplicable, however, for all except that part of the capital that is invested in a corporation from the outset or made as a new contribution to capital of the corporation: the "startup" capital actually supports whatever entrepreneurialism may be going on in that corporation, and new capital contributions may or may not support entrepreneurialism. (Even startups may not be entrepreneurial, but some at least are.) Most investments in corporate stock are not even invested in the corporation--they are just secondary market purchases between investors, so there is no new investment going into the corporate entity. There appears to be very little reason to treat gains from secondary market trades in corporate stock more favorably than labor income for tax purposes--those resources will be invested in something or spent, so we don't need the tax law to incentivize the investment.

The arguments for eliminating corporate tax otherwise usually boil down to a statement along the lines that "people are the only ones that really pay tax, so corporations shouldn't be taxed." That is an a priori conclusion (based on determining that people are the only "real" taxpayers), but somehow it passes for astuteness amongst many tax experts. It is claimed to be based on economic reality--that only people earn income; that it is people that run corporations but there is no "person" that is the corporation; that the corporate tax can be and is passed on from the entity to others that are people--customers, vendors, employees, shareholders. While there is a kernel of truth to each of those rationales, there is also a much larger story that they do not capture. The idea that "only people earn income" ignores the reality of corporate entities of infinite duration that may hoard millions in cash rather than pass it to the shareholder/owners. The idea that the corporation itself isn't a person (which is only relevant, of course, with the corollary that only people pay tax) has been undercut by the expanding scope of the Slaughterhouse Case decisions that treat a corporation as a person for constitutional purposes--including the recent Citizens United case that allows corporations to spend money to influence election campaigns, though they cannot (yet) vote. Though the incidence is not fully certain, one might think that it is most aptly described as passed on to shareholders since there are less corporate earnings to be distributed). If one says that similar passing along occurs whenever one person hires another (family with nanny pays nanny out of service income of family even though they pay taxes on that income; nanny treated as gettting compensation income on which nanny also pays taxes), one is warned that this is playing games and not the way proper economic analysis treats the situation since it is "inherently" different when it is an "entity" that can't "actually" do services except by the actions of the people who own and operate it, so should not be treated as earning income or paying taxes.

One could also say that corporations don't talk so they shouldn't have First Amendment rights. That wouldn't get us far with Citizens United on the books.

As a result, whether corporations are taxpayers or not and whether they have First Amendment rights or not is a matter of law. Right now, our statutory law says corporations are taxpayers and our constitutional law (as interpreted by the Supreme Court) says they also have First Amendment rights.

Remember that the statutory rate is the rate applicable under the statute to "taxable" income rather than economic income. Taxable income is almost always much lower than economic income, since there are both income exclusions (e.g., certain life insurance) and deductions and credits (e.g., the R&D credit, the section 179 "expensing" deduction) that make taxable income considerably less than economic income. As a result, most taxpayers--and especially most wealthy people and big corporations--don't pay anywhere near the statutory tax rate on their economic income. My favorite example in my basic income tax class used to be Dick Cheney. There was a year when he had millions of municipal bond interest income (excluded from taxable income): obviously, his taxable income was much lower than it would have been without that exclusion, so he paid tax on an amount that was considerably less than his economic income. In another year, he took advantage of the so-called "Katrina charitable contribution provision" that permitted taxpayers to completely reduce their taxable income to zero with their charitable contributions (which didn't have to do anything to aid Katrina victims or New Orleans). You can imagine that there'd be someone who typically made $200,000 a year in contributions and who might make $600,000 that year (and not make the $200,000 a year for the next two years) and be much better off taxwise. Of course, the fact that wealthy people own the lion's share of the financial assets of the country gives another advantage here--they can contribute stocks and get deductions for amounts that they've never paid tax on! And on and on...

Obama was correct on one thing: the federal income tax is riddled with provisions that benefit big corporations, especially Big Oil which benefits from "percentage depletion" and others that enjoy considerable benefit from the modified accelerated depreciation provisions (dating back to Reagan's time) and various bonus depreciation and expensing provisions that don't reflect the economics and have added complexity to the Code since then. Scaling back those provisions--eliminating the many subsidies for Big Oil and modifying the provisions for accelerated expensing and depreciation would be a good move.

The corporate expertise in taking advantage of loopholes or in "inventing" them (tax strategy patents, anyone?) results in US corporations pay very little in federal income tax. David Leonhardt discussed that recently in an article about The Paradox of Corporate Taxes, New York Times, Feb. 1, 2011. While noting that companies have various reasons for having low tax bills, including significant losses carried forward from earlier years to offset years of profits and significant purchases of equipment or buildings that are allowed to be "expensed" under today's capitalization and depreciation rules, another reason that many are successful is that they have developed significant expertise at avoiding taxes. Leonhardt reports that GE, for example, paid less than 15% of its corporate profits in taxes between 2005 and 2009.

G.E. is so good at avoiding taxes that some people consider its tax department to be the best in the world, even better than any law firm’s. One common strategy is maximizing the amount of profit that is officially earned in countries with low tax rates. ...

Companies that pay relatively high rates tend to be those that are not expanding rapidly and that are not as ingenious as G.E., at least on taxes. The average total tax rate for the 500 companies over the last five years — again, including federal, state, local and foreign corporate taxes — was 32.8 percent. ...The problem with the current system is that it distorts incentives. Decisions that would otherwise be inefficient for a company — and that are indeed inefficient for the larger economy — can make sense when they bring a big tax break.

But Leonhardt's numbers may make corporations look like better taxpayers than they actually are. Citizens for Tax Justice recently published a study suggesting that the contribution to tax revenues from US corporations is even lower than generally reported. According to CTJ, GE didn't pay anywhere near the 14.7% that Leonhardt claims. "GE's effective tax rate for its U.S. profits was actually just 3.4 percent over that period. Our figure is based on what GE says that it paid in U.S. corporate income taxes (called "current" taxes) divided by what GE says its pretax U.S. profits were (all from GE's annual 10K reports to shareholders, filed with the SEC)." See U.S. Corporations Are Paying Even Less in Taxes Than Recently Reported, Citizens for Tax Justice (Feb. 4, 2011). CTJ suggests that there are several reasons why some reports misreport the US income taxes paid by corporations.

First, some analysts are misreporting how the worldwide taxation system works and thus larding the corporate taxes paid to the US with taxes that corporations pay to other countries. While the US system includes worldwide income in taxable income, it also gives corporations a tax credit for taxes they have paid on their foreign income to other countries, up to the amount of tax that would have been paid in this country. So those taxes shouldn't be counted as part of the US taxes paid. As CTJ explains, "to understand how the U.S. corporate income tax is working, one must focus on U.S. taxes paid on U.S. profits. No one expects Congress to do much about taxes that U.S. corporations pay to the governments of France, Germany, or Japan!"

Second, only the "current" taxes in financial statements (available generally in SEC filings for reporting companies) are relevant. Taxes that are listed as "deferred" may be due and payable but they don't count as taxes yet. As CTJ notes," "Deferred" is a euphemism for "not paid." Corporations can defer (delay) paying taxes if, for example, they enjoy tax breaks for accelerated depreciation, which allow them to take deductions for capital investments sooner than they would if the rules were simply based on the actual life of the investment. A company could eventually pay taxes that it has "deferred." But that doesn't happen very often."